2/16/2009 @ 6:00AM

Richard N. Foster's Innovation Recipe

An eternal student and teacher of capital markets, disruptive innovation and technological change, Dick Foster may be the smartest, most knowledgeable thinker and investor I know. Before launching Millbrook Management Group, LLC, he served as a Senior Partner and Director of McKinsey & Co. for 22 years. In that time, he co-founded the company’s high-tech practice in the late ’70s, chemicals in the early ’80s, health care in the late ’80s and private equity in the ’90s.

He has penned two best selling business books: Innovation: The Attacker’s Advantage (1986) and Creative Destruction (2001) and as senior faculty fellow at Yale teaches the especially relevant course “Managing in Times of Rapid Change.”

A fellow of the American Academy of Arts & Sciences and a member of the President’s Circle at the National Academies, he serves on the Boards of the Council of Foreign Relations, Memorial Sloan Kettering Cancer Center, Yale School of Medicine Dean’s Advisory Board, W. M. Keck Foundation, the Council for Aid to Education, athenahealth and the Trust Company of the West. Mr. Foster received his bachelor’s, master’s and doctorate degrees from Yale University in engineering and applied science.

Josh Wolfe: Let’s define innovation.

Richard N. Foster: There is a group of people who believe that most innovation starts with science and technology development. I am not one of those people. For example, if we look at one of the last creative destruction events, which was the stock market crash in the mid-1970s, some of the most profitable firms to emerge from that era were the Limited, Gap and Home Depot. So the big innovation was big-box retail and all of the cost savings that could accrue from it. To me, that was a business system innovation of massive proportion, and it generated wealth beyond anybody’s imagination.

For example, the Limited earned an average annual return to shareholders of 52% for the 15 years after 1974. If you invested $10,000 in 1974, you would have walked away with $4.6 million 15 years later. It was new and it created a lot of wealth, and those are the two determinants of innovation as far as I’m concerned. If it creates a lot of wealth but it isn’t new, you wouldn’t call it an innovation, and if it’s very new but it doesn’t create any wealth, then I’m not interested.

Is the U.S. losing its edge? Are innovations more likely to come from booming populations in China and India?

The underlying infrastructure for innovation in the United States, particularly science and technology innovation, is unsurpassed by any other place in the world, with the possible exception of Korea and maybe Japan. China and India are totally, absolutely and utterly different. There is nothing about the demand patterns of those countries that replicates the demand patterns of the U.S., and so the innovations that are needed (if we assume that innovations are things that create value for people) in China are not like the innovations needed here. If we impute to China that they are going to come up with the next advance of the Internet, maybe that will happen, but I think we’d be more likely to find greater advances in building and running power plants, since they’re going to need more of those in China than we will need here. They may not look that high tech to us, but they may be very powerful in terms of carbon sequestration, for example.

So you believe innovation is different across cultures?

I think a lot of it comes down to differences in the nature of thought between China and the West. (I won’t comment on India because I’m not as well versed there). There’s a wonderful book called The Geography of Thought by Richard Nisbett, which talks about the differences between Eastern and Western thought, and why those differences exist. The short version, more or less, is that Western thought goes back to Aristotle, and Eastern thought goes back to Confucius. Western thought was very much oriented toward the individual, toward debate. It came from a heterogeneous society that was very analytical and very science-based–the original reductionists. China, on the other hand, was oriented toward the concept of harmony: yin and yang. If things were going really well, they were about to start turning crappy, and if it was going horribly, well, it was going to start becoming good. So history was never finished, everything was in constant evolution. These are big differences–one being individualistically oriented, the other being oriented toward harmony.

So, differences in thought yield different types of innovation?

So up until the age of enlightenment there were two entirely different systems of thought, and that has real implications for the nature of modern-day creativity in those places. For example, until recently, China had no tradition of innovation based on science. They had a lot of tradition of innovation through combining things or doing practical things where there was an immediate end result, but they had no deep sort of reductionist tradition of exploring new concepts and then applying them to create great discoveries.

To take an example from another field, before the era of Keynes, there are almost no famous Chinese economists. Even though they were one of the greatest trading empires in the world, they never tried to get at the underlying theory of why wealth was being created in China. They are just not oriented like that. They will become so, and because they have so many people, even a small percentage of them who think like Westerners will be able to produce thought that looks like Western thought. But they’re not entirely there yet. So from a needs point of view, from an orientation toward science and technology point of view, from a logic of thought point of view, and from the sociology of innovation point of view, the East and the West couldn’t be more different.

Will they eventually merge? I suspect they will, but that will probably be decades away. So I think we’ll see very different patterns of innovation in China and in the West, and I don’t think they’ll necessarily be very competitive.

What are some impediments to innovation in China?

Innovation that makes a difference for people requires capital, and capital requires capital markets. Call it NASDAQ. China doesn’t have that. Even China’s most innovative company (at least the most famous one in the West), Baidu, went public on the NASDAQ. Why did they do that? Because the Chinese exchanges couldn’t possibly handle the volume.

Also, if you get in trouble in China, the court that hears your case is from the same side of the government as the company that you’re suing, so it’s very difficult to raise money to protect minority shareholder rights. There won’t be legitimate capital markets in China unless they change their fundamental political system, and I don’t think that is going to happen in the foreseeable future.

Give me the recipe for what has made the U.S. the most innovative country in the world?

My recipe would be:

1. Active, reasonably fair, and truthful capital markets

2. A common language

3. A huge common market

4. A common currency

5. A transportation system built (thanks to the largesse of the British) to enable the movement of goods around and across the country

6. A set of principal beliefs, [such as] the Constitution, that revere independence

The U.S. had everything going in our favor, and, not surprisingly, those conditions produced some great entrepreneurs: the Rockefellers, the Carnegies, the Mellons, the Fords, all of those families and many more. The combination of all those factors and the social context of our society could not be matched by a single country in Europe, and that was the reason why the culture of innovation and entrepreneurship developed here. And it still flourishes here far better than any other parts of the world.

I love your story of creative destruction in sailing ships. Please share it with my readers.

Sure. The first steam ship sailed around 1830. Yet when we look at some of the first photographs of ships from the early 1870s, a full 40 years later, we see an abundance of sails. The vast majority of investments that went into so-called “innovations” in the ship industry had gone into adding more masts to existing ships and more sails to those masts. Why? Because the incremental cost of building a slightly more advanced sailing ship always looked to be less than the full cost of starting up a steam ship from scratch. So there was no incentive for the incumbents to change to the new innovations, there was only incentive for new entrants to come up with steam ships, and that’s in fact what they did. This went on for over 50 years, and even as steam ships got better and better, the incumbents continued to just add more sails. How could that be? Well, what was really happening was declining share in a growing market. This can often mean increasing sales–even though market share is falling. Your share is falling in a business that’s defined differently than the way you think of it, so you generally don’t even notice when in fact your lunch is being taken and eaten right before your very eyes.

So the big shipbuilders of the time didn’t even realize that sails were about to be relegated to the realms of leisure boats?

Yes. This is one example of a very broad class of problems called confirmation bias, where we tend to only accept information from the outside that fits into our existing mental models, and we don’t actively explore whether our own mental models are actually correct. Certainly, the innovators in the case of the steam ships understood this. The original steam ship builders knew perfectly well that the steam ship could not be competitive initially with the sailing ship. So they did what many innovators do, they came up with a hybrid product, which was a steam ship that had sails on it (or a sailing ship that had a steam engine in it, depending on your perspective).

Over time they improved the efficiency of the steam engine, which allowed the ship to go further and further and sail when there was no wind, and eventually the steam engines became so good that eventually, after 70 or 80 years, they could take the masts and the sails right off and just have a full blown steam ship, and that’s in fact how the steam ship evolved. You could find steam ships up until the 1920s and 30s that were built with masts even though there was no capacity to put sails on them! Such was the nostalgia associated with the sailing ships. The basic idea was a confirmation bias, and it’s a tremendous threat to companies trying to make a proper economic decision, which is often the decision to move onto a new technology. One doesn’t have to look too far north of Detroit to think of current examples of a similar sort of thing

How does one balance short-term thinking with the prospect of developing new technologies for long-term impact?

At the end of the day, it is true that the capital markets pay attention to what’s happening in the short term. If our country is dissatisfied with our balance between the long term and the short term, then one can argue that it’s the function of government to pick up that slack and ensure we’re making sustained long-term investments that will eventually be picked up in the private sector. Our government is notoriously horrid at this. No matter how short-term-oriented businesses may be, government has been worse.

For example, we started the Synfuels Corp. in 1982 because the price of oil was high and headed higher and we needed alternative fuels. Then the price of oil came down in the not-so-far-fetched analogy to the current time, and we shut down Synfuels Corp. Had the company continued at a modicum of effort at a very low cost compared to anything these days, we would probably have synthetic fuels in this country right now, and we wouldn’t be stuck and beholden to foreign nations for one of our most precious resources.

For the longer term, I would argue that basic research is an appropriate government function, and we ought to be focusing on how to keep those programs alive. But congressmen get elected every two years, so is it realistic to expect them to lobby for long-term initiatives? Washington needs to stop pointing the finger at everyone else and look inward to figure out how to maintain long-term investments in programs that are strategic for the U.S. We certainly know how to do that for the military, we ought to be able to do that in other areas as well.

What about public companies? How can they invest in long-term projects when they’re so focused on meeting quarterly earnings?

We ought to put this in perspective. I am a strong believer that the price of a stock is the consequence of the beliefs of the net present value (NPV) of the future cash flows of the enterprise. If you look how much of that NPV is contributed by earnings in the next five years, that number is on the order of 10% to 15%. That means that 80% or more of the value of any stock is based on an estimate of what the earnings will be five years or more into the future. That hardly qualifies as short-termism. I think it’s pretty tough to make the economic argument that the value of a stock is dominated by the short term; in fact, it’s dominated by the longterm.

Now, there is difficulty in all of this. Companies that decide to innovate beyond the scope of their current businesses (as defined by analysts), and make investments in areas that are not in their sweet spot, will be judged with some skepticism by the market, and they may or may not be given credit for these investments. If they ARE given credit, then there’s no short-term problem. But if they aren’t given credit, then you have an issue.

Take SAP, the great German enterprise software manufacturer, as an example. They tried for years to develop software for small- and medium-sized enterprises (SMEs), which is a market segment outside from their core customer base. A lot of analysts thought the company would never be able to develop a business system that would be able to sell to the SME segment. So when the company started to invest several hundred million euros a year into developing an SME equivalent of their software, the analysts thought it was a waste of money, and as a consequence there was no credit given in the calculation of NPV for any return on that investment, and the stock price of SAP came down.

At some points the price got so low that SAP became vulnerable to takeover by Oracle, which was the very thing they were trying to avoid through their investments in the first place. What’s the problem here? The problem is that the analysts had a different view of SAP’s ability to succeed than SAP had. Who was right? Who knows? How can you know? I don’t think that’s a manifestation of short-termism. I think it’s a difference in point of view about the future of a business.

What can we expect from the current economic forecast?

We are in the time of creative destruction. For whatever set of reasons, planned or unplanned, a 40% reduction in the capital value of the world’s markets will wipe many people out, and many businesses and enterprises will fold. Out of this, as with every other event of this sort, will come all kinds of new enterprises. They will come out in profusion, and the new shoots will grow in the forest, and there’ll be another great forest and we will move on.